Transactions: July 20, 2009

Let me get this straight. Are you saying that the rational market is dead as a stuffed parrot? That homo economicus, the utility-maximizing everyman that animates markets and directs the invisible hand, can keep his latinate homo prefix but requires alterations in the economicus suffix? This is a little disturbing. This would suggest that if markets aren't optimally efficient -- and recent trends, to say the least, are not promising -- then we as members of the human herd are less rational, logical, intelligently self-interested than we once thought. It means we do things for reasons outside our economic self-interest, which is shocking. We do not, consciously or unconsciously, tap our utility calculator every time we buy a falafel. We are left exposed to demons. We are free agents, random, unpredictable. Our little ticks, our irrationalities do not cancel themselves out in giant market netting mechanisms, leaving a distilled residue of rationality behind, which we can then index to. Our idiosyncrasies, our flaws, our sins, our giant boo-boos do not get arbitraged away. Equilibrium is a random price point; true value is elusive.

Holy cow, Mr. Spock, this is a scandal. Let's face it: A self-cleaning market appeared to be a profound innovation on par with paper money and the automated teller machine. And now it may be gone. Dead! Moreover, over 40 years the rational market produced a formidable assemblage of tools and techniques. Now they lay scattered across a forlorn landscape: modern portfolio theory, the capital asset pricing model, efficient markets, asset allocations, indexing, option-pricing models, alphas, betas, the belief that everything will turn out swell if you invest along the efficient frontier long enough. What do we do with this stuff? How do we build efficient portfolios? How do we set corporate hurdles? Is this heap of intellectual property useless, obsolete, anachronistic? Do we get Harry Markowitz's Nobel back?

More to the point, what replaces the model of human psychology that curls up inside the rational model, namely, endlessly calculating homo economicus? If we are no longer utility maximizers, what the hell are we? Hedonists? Vegans? Lovers of truth and beauty? Nihilists? The answer currently is to prop glassy-eyed homo economicus up in the chair, stick a pipe in his mouth and pretend he's just fine. That can only last so long. Meanwhile, a quiet little search begins for a replacement. Freud, Marx, Thomas Aquinas, Augustine and Oprah apply for the position, but they lack investing tools. Then there's the school of behavioral economics, which did a lot of spade work to undermine homo economicus in the first place. Alas, the behavioral gang lacks the quantitative bent and solipsistic tendencies of rational markets; that is, the powerful belief that markets are rational because they are, well, rational. In the behavioral mode, we are a bundle of emotions, misperceptions, credulity. We have a weakness for stories and rumor. We spend too much time paying attention to everyone else. We naturally form crowds; we are rarely autonomous. We have our rational moments, but we are beset by animal spirits, which come and go on no set schedule. We do not know the cause of those swings, but we have a theory: evolution. We are hard-wired to act like chimps or chumps, since our behavior traces down the tree of life to when we were gamboling on its vines, grabbing fruit, fleeing tigers. We can't really help it. We are what our DNA, shaped and fired by conditions a million years ago, tells us to be. This explains, though it does not prove, our yen for short-term gratification, but it fails to explain why millions of us are sitting on 401(k)s for a friggin' eternity.

Where does this leave us? Up the tree, pondering the limitations of empiricism. Behavioral theories, economic or evolutionary, may actually capture us better in our quotidian variousness, but how do we get to retirement, which is the deepest question we seem prepared to ask? We remain utilitarians without useful tools. Without homo economicus, in all his (and I see him as a repressed male) splendid, if rigid, simplicity, we resort to pre-Friedmanite market theories that either traffic in mystery, like technical analysis, or empirically driven stabs in the dark, like momentum trading or the January effect, which tend to evaporate as soon as everyone finds out. The truth is, while crotchety homo economicus might have been slightly -- well, perhaps a lot -- reductionist, everyone accepted him, and we levitated together. Now we're left coping with unhinged markets, diminished self-regard and great anxiety. There is reportedly a marvelous world out there that contains a great diversity of wonders beyond our ruined walls and shattered cages. There's just no free lunch.